The Icelandic parliament, by the narrowest of margins and broadly on party lines, has just decided to apply for EU membership. If the application is successful and approved by a referendum, Iceland might join the EU in four years. However, serious obstacles, both domestically and within the EU, make the eventual outcome quite uncertain.

Domestic opposition

Iceland enjoys an auxiliary membership in the EU, as a member of the European Economic Area (EEA), which gives it many of the benefits of membership including access to markets and labour mobility. At the same time, the majority of the population has consistently opposed EU membership.

The key sector in the Icelandic economy has traditionally been fishing, especially as the largest generator of exports. Since 1983, fisheries in Iceland have been regulated under a quota system, which combines economic principles and the advice of the country’s experienced marine scientists to avoid the tragedy of the commons plaguing EU fisheries.

Although this system is disputed politically, it can be defended as relatively sustainable and well managed, from economic and biological points of view. Consequently, Iceland has been successful in leveraging its fishing industry to deliver one of the richest economies in the world.

By contrast, fisheries may be the worst part of the worst run department of the EU, the Common Agricultural Policy, which has led to problems such as overfishing, overinvestment, inefficiency, and low profitability. Many Icelanders fear that by joining the EU they would have to give up their relatively successful fisheries management system for an inferior one.

In addition, Icelandic control over its fisheries was hard-fought, up to the point of the breaking of diplomatic relations with the UK and skirmishes between the Icelandic Coast Guard and the UK Navy. This means there is strong opposition to allowing foreign fishing boats operating in Icelandic waters, and there are widespread fears that EU membership would eventually lead to that.

This may be the key reason why opinion polls consistently indicate that the majority of the population opposes EU membership. However, the severity of the financial crisis in Iceland has started to change public opinion.

These views are changing with the crisis

The worst hit country in the current global crisis is Iceland (see my October Vox column). Its entire banking system collapsed in October last year, and since then the country has operated under IMF mandated capital controls, with the economic situation deteriorating steadily.

One of the main contributors to its crisis was inappropriate monetary policy and currency mismanagement. For this reason, there is a strong general feeling in Iceland that its currency needs to be replaced with something more solid, typically the euro. Unilateral adoption of foreign currency, especially the euro, has been mooted, but it would not be a feasible course for Iceland.

That leaves joining the euro system as a means to take up the euro. First, however, Iceland needs to join the EU, and that may be the necessary impetus for EU membership to be approved by Icelanders.

But this issue is not clear-cut, because if Iceland joins the EU on schedule in 2013 it would then need many years of both macroeconomic and currency stability before it could join the euro. If stable currency and euro membership is the raison d'être for joining, by the time the currency stabilisation has been achieved the need for adopting the euro will be much less.

Opinion polls have consistently shown majority opposition to EU membership, even during this crisis. This is changing, and significant parts of the population have not made up their mind about eventual EU membership. There is public support for applying, but many of those are waiting to see the details of the eventual agreement.

Opposition of EU member countries

Iceland’s application to the EU faces two types of difficulties: general EU concerns about enlargement and specific issues relating to Iceland.

For the EU, admitting Iceland should be relatively straightforward, since its GDP per capita has been amongst the highest in the EU and it already has taken on board most of EU regulations because of its EEA membership. However, some obstacles remain.

It seems unlikely that the EU would want to admit new members until the issue of the Lisbon Treaty has been settled, which may happen this fall or later. In addition, it may be felt that Iceland’s membership should happen at the same time or after that of other applicants, in particular Croatia.

The main specific EU opposition to Iceland’s membership is likely to be the ongoing problem of Icesave. A few years ago when Icelandic banks started facing difficulty borrowing in wholesale markets, they hit on the idea of creating high-interest savings accounts, first in the UK, followed by the Netherlands. By offering interest rates perhaps couple of percent over prevailing market rates, they were able to raise substantial amounts from European savers.

Two Icelandic banks, Kaupthing and Landsbanki, engaged in this. The former operated its European savings operations by a subsidiary, so that their deposits were insured by the host country. By contrast, Landsbanki, using the name of Icesave, operated its saving scheme as a branch, meaning that the deposits were regulated and insured in Iceland.

When Landsbanki collapsed last October, it had accumulated perhaps €6.5 billion in deposits. Around €4 billion was insured by the Icelandic deposit insurance fund, but its reserves only covered a small fraction of that. The EU insists that the government of Iceland make up the shortfall, even though EU laws are not clear on the legal obligation (see my February Vox column).

The reason is most likely that the EU does not want any public doubts about the integrity of this deposit insurance scheme to emerge. Throughout the crisis, the EU has consistently and firmly maintained this position up to the point of holding up Iceland’s IMF agreement last November until Iceland agreed in principle that it was responsible for the Icesave obligations (see Hrunið, 2009).

The UK and the Netherlands have now come to an agreement with the government of Iceland on the Icesave obligations. It only needs parliamentary approval. Reading the agreement, it is clear that the Icelandic government negotiated it from a point of weakness and incompetence, unnecessarily conceding valuable rights (Danielsson and Sigurdsson 2009). Similar views have been expressed by a number of prominent lawyers and economists in Iceland.

Icelandic government debt without these obligations amounts to perhaps 150% of GDP; adding the Icesave obligations will take that to well over 200%. From a different perspective, the €4 billion Iceland has to assume is equivalent to the UK assuming €800 billion, if adjusted for population size.

Government debt of over 200% of GDP, with a substantial proportion in foreign currency, is unprecedented among Western countries. It is hard to see how debt levels of this magnitude could be sustained, and I fear that a sovereign default is a possible eventuality.

If Iceland is seen to be heading for a sovereign default, it is likely that the EU would be more reluctant to admit it.

These facts imply that there is a considerable opposition within Iceland to the Icesave agreement, and parliament may well decide to reject it in its current form.

That however would upset Iceland’s application to the EU: “Reykjavik insists the Icesave issue is separate from the debate over EU membership but analysts predict the UK and Netherlands would block Iceland from joining if it reneged on the deal” (Financial Times 2009). Dutch parliamentarians have expressed similar views (De telegraaf 2009).

Conclusion

The Parliament of Iceland narrowly voted to apply to the EU. Membership is far from certain as significant issues remain on both sides. The key ones are fishing, the Icesave deal, and the consistent opposition of the Icelandic population to EU membership. Accession of Iceland into the EU is very much in doubt.